DeMarco won’t allow principal reduction on Fannie, Freddie loans

After a detailed analysis, the Federal Housing Finance Agency has decided not to allow permanent principal reductions on underwater home mortgages backed by Fannie Mae and Freddie Mac, the agency’s head Ed DeMarco said Tuesday.

DeMarco said the agency, which oversees Fannie and Freddie has decided not to allow permanent reductions under the Treasury Department’s Home Affordable Modification Program Principal Reduction Alternative because “the anticipated benefits do not outweigh the costs and risks.”

DeMarco has been under heavy pressure from the Treasury Department and some economists and members of Congress to reverse the agency’s prohibition against permanent principal reductions on Fannie and Freddie loans. The agency does allow temporary reductions – known as principal forbearance – on some underwater loans. But it has opposed permanent reductions in part because if the market turns around, the homeowner reaps all the gains from the home-price appreciation.

Advocates of principal reduction say it would reduce Fannie and Freddie losses and save taxpayers money because homeowners who are underwater — or owe more than their homes are worth — are more likely to default on their loans. Reducing their principal makes them more likely to continue or resume paying.

In January, Treasury announced it would triple the incentives paid to investors who permanently write down principal on deeply underwater loans under its HAMP Principal Reduction Alternative. For the first time, it offered these payments to Fannie and Freddie.

An earlier analysis that factored in the tripled incentives concluded that Fannie and Freddie losses would be reduced by $1.7 billion if they allowed permanent principal reductions under this alternative. But that includes $3.8 billion in incentive payments from the Treasury, “which would imply a net cost to the taxpayer overall of $2.1 billion,” DeMarco said.

DeMarco wanted to refine this analysis before making a decision on principal reductions and had promised a response by late April, but deferred it pending further study.

The analysis released Tuesday estimates that letting Fannie Freddie permanently reduce principal on loans that qualify for the Treasury’s program would result in a net benefit to taxpayers ranging from zero (worst-case scenario) to $1 billion (best-case), depending on borrowers’ current debt-to-income ratios.

However, the best-case assumes that every one of roughly 500,000 borrowers eligible for a principal reduction under this scenario would apply, complete a trial period and earn a permanent modification.

In the more likely scenario — that only 15 to 50 percent would carry through — the net savings to taxpayers would shrink to between $100 million and $500 million, the analysis says.

However, this analysis does not factor in the moral hazard risk. To qualify for a principal reduction under HAMP, borrowers must be underwater and behind on their mortgage payment or at imminent risk of default. If borrowers who can pay their mortgage stop paying to win a principal reduction, the net benefit to taxpayers would shrink. The analysis suggests it would take only 3,000 to 19,000 of thes so-called strategic defaulters to wipe out any benefit to taxpayers.

In a letter Tuesday to the heads of the Senate banking committee, DeMarco said that principal reductions “would not make a meaningful improvement in reducing foreclosures in a cost effective way for taxpayers. Yet there are continued improvements that can and should be made to strengthen the Enterprises’ loss mitigation and borrower assistance efforts, and to improve the operation of the housing finance market. These efforts include further streamlining refinance opportunities, enhancing the short sale process, and reducing lender uncertainty that could inhibit new mortgage lending.

DeMarco’s decision is renewing cries for his ouster from the likes of New York Times columnist Paul Krugman and Natalie Foster, CEO of Rebuild the Dream.

In a letter to DeMarco, Treasury Secretary Timothy Geithner highlights the more positive aspects of the analysis. If Fannie and Freddie were to allow permanent reductions, “taxpayers would save as much as $1 billion on a net basis,” he wrote and urged DeMarco “to reconsider this decision.”